INTRODUCTION

A lender of last resort is ready to lend money to banks and other financial institutions when others are not. In this chapter we delve into the concept of a lender of last resort, including its benefits and risks. We further delve into various views of the function of the lender of last resort and its application. This chapter concludes through exploring the role of the U.S. Federal Reserve during the Great Depression and the Credit Crisis of 2007–2009.

After you read this chapter you will be able to:

• Define the role of a lender of last resort.
• Understand why a lender of last resort is important.
• Understand the risks associated with a lender of last resort.
• Learn about the classical view and alternative views of the function of the lender of last resort.
• Learn about the Great Depression and U.S. Federal Reserve's response.
• Learn about the Credit Crisis of 2007–2009 and U.S. Federal Reserve's response.

LENDER OF LAST RESORT CONCEPT

A central bank such as the U.S. Federal Reserve is described as “lender of last resort” as it is ready to lend money to banks and other financial institutions when others are not. In a review published in Financial Stability Review, Freixas et al. (1999) define the role of a lender of last resort:¹

The discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source.

The adverse shock can be caused by internal factors, such as poor management decisions, or external factors, such as a market crisis. The existence of this safety net enhances the confidence that others have when lending to financial institutions. A lender of last resort has no other lender to turn to should it face stress. Hence, a crucial characteristic of a lender of last resort is its responsibility to avoid drains of its resources that could erode confidence in its ability to act as a lender of last resort.

Freixas et al. (1999) note the distinction between emergency lending that occurs when a financial institution is illiquid but solvent, versus risk capital support for insolvent financial institutions. Illiquidity can occur due to a bank run, where depositors demand the withdrawal of their deposits from financial institutions whose assets are illiquid. Illiquidity can also occur due to the failure of the interbank market, making it difficult for a financial institution to use interbank borrowing to source liquidity. The lender of last resort can provide the financial institution liquidity in exchange for illiquid assets, increasing its liquidity without altering its balance sheet. Emergency lending may also occur in the form of risk capital support for insolvent institutions. Such support can avoid the instability caused by insolvency.

While the benefits to financial stability associated with a lender of last resort are straightforward, the cost is moral hazard. A financial institution will be more willing to engage in activities that expose it to liquidity risks and insolvency risks if it knows that the lender of last resort is willing to engage in emergency lending should these activities lead to crisis. Further, counterparties to a given financial institution will not monitor its creditworthiness as carefully if they know that emergency lending is available should the financial institution face a crisis. An important way to address moral hazard is ambiguity surrounding the willingness of the lender of last resort to provide emergency lending. With such ambiguity, financial institutions will be less willing to engage in activities that may require such lending, and counterparties will more carefully monitor the creditworthiness of financial institutions, as they do not know what will actually happen should a crisis occur.

HENRY THORNTON, WALTER BAGEHOT, AND ALTERNATIVE VIEWS

Reference to the concept of lender of last resort has been identified as early as 1797 when Francis Baring used the expression dernier resort (last resort) to describe the role of the Bank of England.² However, historians attribute the development of the concept to Henry Thornton and Walter Bagehot: Thornton in his 1802 text, “An Inquiry Into the Nature and Effects of the Paper Credit of Great Britain,” and Bagehot in his 1873 text, “Lombard Street.” While academics have highlighted differences in their approaches, the commonalities across their approaches represent the classical view of the purpose of the lender of last resort—to provide the funds necessary should a panic occur. Thomas M. Humphrey summarizes the commonality of the approaches of Thornton and Bagehot:³

Thornton and Bagehot believed the LLR had the duty (1) to protect the money stock, (2) to support the whole financial system rather than individual institutions, (3) to behave consistently with the longer-run objective of stable money growth, and (4) to preannounce its policy in advance of crises so as to remove uncertainty. They also advised the LLR to let insolvent institutions fail, to lend to creditworthy institutions only, to charge penalty rates, and to require good collateral. Such rules they thought would minimize problems of moral hazard and remove bankers' incentives to take undue risks.

Michael D. Bordo notes three alternatives to the classical view.⁴ One alternative is for the lender of last resort function to be implemented exclusively using open market operations, as proposed by Marvin Goodfriend and Robert King,⁵ rather than through sterilized discount window lending. A second alternative is that of Charles Goodhart, which advocates for central banks to provide temporary assistance to insolvent banks.⁶ A third alternative is the free banking approach, which takes the view that there is no need for a government authority to act as the lender of last resort—instead, the removal of legal restrictions on the banking system would allow free-market mechanisms to panic-proof the banking system.

In a 1993 speech, Eddie George, the governor of the Bank of England at the time, details five principles of last resort assistance.⁷ These principles are indicative of how the varying views of the function of the lender of last resort are applied in practice:

1. “We will explore every option for a commercial solution before committing our own funds.”
2. “Central banks are not in the business of providing public subsidy to private shareholders.”
3. “We aim to provide liquidity; we will not, in normal circumstances, support a bank that we know at the time to be insolvent.”
4. “We look for a clear exit.”
5. “We usually try to keep the fact that we are providing systemic support secret at the time.”

THE FED'S ROLE IN THE GREAT DEPRESSION

The Great Depression formally occurred between 1929 and 1934, but its effects lingered on for many years afterwards. The Great Depression was accelerated by the stock market crash of 1929, which led to enormous uncertainty, which led to a drop in consumption.⁸ While centered in the United States, the Great Depression also significantly impacted nearly all countries.

In the United States, the Great Depression was characterized by a 36.21% Real GDP decline peak to trough.⁹ It was also characterized by CPI decline peak to trough of 27.17% and severe unemployment, reaching a maximum value of 25.36%.¹⁰

The stock market crash of 1929 played an important role toward the beginning of the Great Depression. The continued decline, however, is attributable to banking panics. Friedman and Schwartz identify four banking crises during the Great Depression, including banking panics in fall 1930, spring 1931, fall 1931, and winter 1933.¹¹ While Friedman and Schwartz allow for the possibility that the first crisis was due to poor loans and investments on the part of banks during the 1920s, they attribute the subsequent crises to runs on banks in which depositors withdrew their deposits. As a result:¹²

Banks had to dump their assets on the market, which inevitably forced a decline on the market value of those assets and hence of the remaining assets they held. The impairment in the market value of the assets held by banks, particularly in their bond portfolios, was the most important source of the impairment of capital leading to bank suspensions, rather than the default of specific loans or of specific bond issues.

The banking failures impacted the economy in a number of ways, economics professor Christina Romer has noted. These include a direct decline of the money supply, which resulted in an increase in real interest rates; depression of consumer spending and investment due to the resulting pessimism; and disruption of the intermediation function of banks.

Friedman and Schwartz note a paradox: Assets for which there was an active market were perceived by bank examiners as the most impaired, due to clear decline in the obtainable market value. Conversely, assets for which there was no active market were typically carried at face value, and therefore were not perceived as impaired. This meant that the threat to bank solvency came from its most liquid assets!

The response of the Federal Reserve was limited, focused on more liberal valuation of assets by bank examiners. Friedman and Schwartz attribute the Fed's failures to address the crises in a comprehensive fashion to a number of factors. These include the Fed's “limited understanding of the connection between bank failures, runs on banks, contraction of deposits, and weakness of the bond markets” as well as four additional circumstances:¹³

1. “Federal Reserve officials had no feeling of responsibility for nonmember banks. In 1921–29 and the first ten months of 1930, most failed banks were nonmembers, and nonmembers held a high percentage of the deposits involved.”
2. “The failures for that period were concentrated among smaller banks and, since the most influential figures in the System were big-city bankers who deplored the existence of smaller banks, their disappearance may have been viewed with complacency.”
3. “Even in November and December 1930, when the number of failures increased sharply, over 80 percent were nonmembers.”
4. “The relatively few large member banks that failed at the end of 1930 were regarded by many Reserve officials as unfortunate cases of bad management and therefore not subject to correction by central bank action.”

THE CREDIT CRISIS OF 2007–2009

The Credit Crisis of 2007–2009—sometimes referred to as the “Great Recession”—was the worst financial crisis in the United States since the Great Depression.¹⁴ While significant, most would argue that it was nowhere near as severe as the Great Depression. While it is difficult to easily compare two separate crises, the different outcome may be due to the fact that unlike the Fed's response to the Great Depression, the Fed responded vigorously to the Credit Crisis of 2007–2009.

The Credit Crisis was driven by problematic mortgage products and practices, such as interest-only adjustable-rate mortgages, no-documentation loans, and others. These mortgages experienced a significant decline in value, which left financial institutions vulnerable and triggered a panic and the withdrawal of funding by short-term lenders. The decline in the value of mortgage products took place in an environment characterized by private-sector and public-sector vulnerabilities. According to Ben Bernanke private-sector vulnerabilities included excessive leverage, excessive use of short-term funding, poor monitoring by banks, and extensive use of exotic instruments, while public-sector vulnerabilities included gaps in the regulatory system, failures of regulation and supervision, and inadequate capital.¹⁵

Three broad types of tools were used in the Fed's response to the Credit Crisis:¹⁶

1. Provision of liquidity to financial institutions
2. Provision of liquidity directly to participants in key credit markets
3. Expansion of open market operations

The provision of liquidity to financial institutions, the classic lender of last resort response, took place through the discount window through which financial institutions traditionally borrow from the Fed, as well as various facilities that were created in response to the crisis, including the Term Auction Facility, the Primary Dealer Auction Facility, and the Term Securities Lending Facility. The provision of liquidity directly to participants in key credit markets included the Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility. The expansion of open market operations included the monthly purchase of tens of billions of mortgage-backed securities and Treasury securities, which kept long-term interest rates low.

KEY POINTS

• A lender of last resort is ready to lend money to banks and other financial institutions when others are not, which enhances the confidence that others have when lending to financial institutions.
• The lender of last resort can provide the financial institution liquidity in exchange for illiquid assets, or risk capital support for insolvent institutions.
• A cost associated with a lender of last resort is moral hazard, as financial institution will be more willing to engage in risky activities and counterparties will not monitor creditworthiness as carefully. Ambiguity surrounding the willingness of the lender of last resort to provide emergency lending can reduce moral hazard.
• Historians attribute the development of the classical view of the lender of last resort concept to Henry Thornton and Walter Bagehot. While their approaches differ somewhat, among the commonalities in their views is that the duty of the lender of last resort is to protect the money stock, provide support to the entire financial system rather than individual institutions, to behave consistently, and pre-announce policy.
• Alternative views of the function of the lender of last resort focus exclusively on open market operations; provision of temporary assistance to insolvent banks; and a free banking approach that takes the view that there is no need for a government authority to act as the lender of last resort and instead advocates the removal of legal restrictions.
• While the stock market crash of 1929 played an important role toward the beginning of the Great Depression of 1929–1934, the continued decline is attributable to banking panics, including banking panics in fall 1930, spring 1931, fall 1931, and winter 1933. The response of the Federal Reserve was limited, focused on more liberal valuation of assets by bank examiners.
• While the Credit Crisis of 2007–2009 was the worst post–World War II financial crisis in the United States, it was less severe than the Great Depression. The different outcome may be due to the fact that unlike the Fed's response to the Great Depression, the Fed responded vigorously to the Credit Crisis of 2007–2009.
• Three broad types of tools were used in the Fed's response to the Credit Crisis of 2007–2009: provision of liquidity to financial institutions; provision of liquidity directly to participants in key credit markets; and expansion of open market operations.